Taxation For Decision Makers, 2017th Edition Solution Manual

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Solutions to Chapter 1 Problem AssignmentsCheck Your Understanding1. [LO 1.1]What is a tax?What is a tax?How does a tax differ from a fine?Solution:A tax is a payment thatisnot voluntary butisrequired to be paid to a governmentalunit to support its operations; it is not based on the value of goods or services theperson or business receives, however. A fine is levied as a result of an unlawful act.2. [LO 1.1]ConstitutionalAuthorityWhat Constitutional Amendment allowed implementation of an income tax? In what year wasit ratified?Solution:The federal income tax system as we know it today did not begin until 1913 whenthe 16th Amendment to the U.S. Constitution wasratified. The 16th Amendmentgave Congress the power to lay and collect taxes “on income, from whatever sourcederived,” without the previous requirement that all direct taxes be imposed basedon population.3. [LO 1.1]Current Tax CodeWhich version of the tax code is applicable today?Solution:The Tax Reform Act of 1986 was so extensive, the Code was renamed theInternalRevenue Code of 1986. Any current changes to the tax laws are now amendmentsto theInternal Revenue Code of 1986.4. [LO 1.1]Tax ExpendituresDefine tax expenditure?Solution:Tax expenditures can take the form of special exclusions, deductions, credits orpreferential rates for specific activities. These tax expenditures result in a reductionin the revenue that would becollected under a more comprehensive income tax.5. [LO 1.1]SALTWhat is a SALT practice?Solution:The practice ofstateandlocaltaxation is commonly referred to as a SALT practice.6. [LO 1.1]Franchise TaxHow does a franchise tax differ from anincome tax?Solution:A franchise tax is an excise tax based on the right to do business or own property ina state. It is, however, usually determined based on corporate income so would, ineffect, simply be another name for the income tax.7. [LO 1.1]State Income AllocationWhat three factors determine the percentage of corporate income allocated to a particularstate?Solution:The three-factor allocation formula uses a percentage of corporate sales, payroll

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2Solutions Manual for Taxation for Decision Makerscosts, and tangible property allocated to the state.8. [LO 1.1]Employment TaxesWhat employment taxes are imposed on an employee and an employer?Solution:An employee pays the Social Security and Medicare (FICA)tax; the employer alsopays an equivalent Social Security and Medicare (FICA)tax, but the employer alsomay have to pay an unemployment tax.9. [LO 1.1]Wealth TaxesWhat is the most common wealth tax and how is it levied?Solution:The most common wealth tax is the real property tax based on the fair market valueof property owned by an individual or a business.10. [LO 1.1]Intangible TaxWhat property is subject to the intangible tax?Solution:Theintangible tax is levied on intangible propertysuch asreceivables, stocks,bonds, and other forms of investmentinstruments owned by businesses andindividuals.11. [LO 1.1]Estate and Gift TaxExplain theintegration of the gift and estate taxes.Solution:Property that is given away during a lifetime that exceeds a certain amount issubject to a gift taxafter using up a lifetime exemption. When the person passesaway, property that the person still owned (had not given away) is now subject tothe estate tax. Any gift tax exemption that has not been used by the decedent is thenavailable as an exemption from the estate tax.Thus, a decedent’s estate escapestaxation unless his or her total lifetime taxable gifts plus taxable transfers at deathexceed the lifetime exclusion.12. [LO 1.1]Consumption vs Income TaxDifferentiate a consumption based tax from an income tax and illustrate withan example.Solution:A consumption tax is levied on purchases of goods or services that are going to beused or consumed. The most common consumption tax is the sales tax, but thevalue-added tax is another form used in many countries outside the United States.The income tax is based on the value of money or goods that are received, whetherit is spent or saved. An income tax will tax money that is going to be saved ratherthan spent while the consumption tax only taxes money that is spent. Theconsumption tax is thought to encourage savings.13. [LO 1.1]Wealth TaxesDifferentiate a wealth tax from a wealth transfer tax and give examples of each.Solution:A wealth tax is based on the value of wealth that aperson has at a particular pointin time. The real or personal property taxes are wealth taxes. The wealth transfertax is based on the value of money or property that is passed on to another person.The estate, gift, and inheritance taxes are wealth transfer taxes.

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Chapter 1: An Introduction to Taxation314. [LO 1.1]Income TaxesOver what ranges of taxable income in 2016 will the total income tax liability two personswith equal incomes who file as single individuals equal their income tax liability if they filejointly as a married couple?Solution:Two persons with taxable income of $75,950 each will pay the same total tax as amarried couple with taxable income of $151,900. Above $151,900 the marriedcouple’s rate increases to28% while each of the single persons does not reach thatrate until taxable income isover$91,150.15. [LO 1.2]Types of TaxesDifferentiate a progressive tax system from a proportional and a regressive system and giveexamples of each.Solution:The income tax system in the United States is a progressive system; that is, asincome increases, the tax rate increases and the person pays a greater percentage ofincome as a tax. A person who has $9,000 of taxable income will pay $900 in taxes(10%). A person who makes $18,000 will pay $2,236.25 ($927.50 + .15 ($18,000-$9,275). $2,236.25/$18,000 = 12.42%. A regressive tax system imposes a lower taxrate as income increases; that is, a person pays a decreasing percentage of theirincome in taxes as income increases. The Social Security portion of the FICA tax isa regressive tax; as the taxpayer’s income on which the tax is based exceeds amaximum, the tax is no longer collected and the rate declines. A proportional taxwould collect the same percentage of tax on the tax base, regardless of the size ofthe base. The sales tax is a proportional tax as the same percent tax is collectedregardless of the amount spent.16. [LO 1.2]Income Tax RatesWhat basic tax rates apply to the ordinary income, dividend income, and interest income of anindividual? What are they for a corporation?Solution:Individuals have basic tax rates of 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%that apply to their ordinary income and their interest income. The basic tax rates fortheir dividend income are 0%, 15%, and 20%.Corporations have no tax-favoredincomes so they pay tax on all income at rates of 15%, 25%, 34%, and 35%,excluding surtaxes on certain portions of income that ultimately produce a flat taxof 35% on income above $18,333,333.17.[LO 1.2]Income Tax RatesWhat tax rates apply to an individual’s capital gains and to which tax brackets do each of thisrates apply?Solution:Individual’s short-term capital gains tax rates are the same as the tax rates onordinary income. A single individual’s long-term capital gains rates are 0% onlong-term capital gains (LTCG)from 0 to $37,650; 15% on LTCG from $37,651 to$415,050, and 20% on LTCG exceeding $415,050.18. [LO 1.3]Canons of TaxationBriefly explain Adam Smith’s four canons of taxation.

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4Solutions Manual for Taxation for Decision MakersSolution:The basic idea of equity is that persons with similar incomes will face similar taxes.Thus,individualseach with $200,000 in taxable income will pay the same amountof tax. A tax meets the criterion of economy when the amount of revenue it raises isat an optimum level after the costs of administration and compliance areconsidered. The canon of certainty would dictate that a taxpayer know withreasonable accuracy the tax consequences of a transaction at the time thetransaction takes place. The last canon of convenience states that a convenient taxis one that would be readily determined and paid with little effort.19. [LO 1.3]Equity ConceptsDifferentiate horizontal from vertical equity.Solution:Horizontal equity would require persons with equal incomes pay equal amounts oftaxes. Vertical equity wouldrequire persons with higher incomes to pay a higherpercentage of their income than persons with lower incomes. This is the basis of theU.S. tax system.20. [LO 1.4]Taxable PersonsWhich three taxable persons pay all of the income taxes?Solution:Only individuals, regular (or C) corporations, and fiduciaries (estates and trusts)pay income taxes.21. [LO 1.4]Gross IncomeDefine gross income.Solution:The term gross income is an all-inclusive term that includes income from allsources that are not specificallyexcluded.22. [LO 1.4]Basic Tax ModelBriefly describe the basic elements of the tax model.Solution:The basic elements of the tax model are gross income, less deductions, that equaltaxable income or loss. To this itapplies the applicable tax rate to determine thegross tax liability. From this tax credits and prepayments are deducted to determinethe tax liability owed or the refund due.23. [LO 1.4]Capital LossesDifferentiate the tax treatment of an individual’s capital losses from the tax treatment ofcorporate capital losses.Solution:An individual may deduct up to $3,000 ofcapital losses in excess of capital gainsannually; the excess may be carried forward to succeeding years. A corporationcanonly offsetcapital lossesagainst capital gains;they are not deductible against otherincome. Instead the corporation first carriesthe losses back to thethreepreviousyears and then forward for 5 years.24. [LO 1.4]Basic Income Tax RatesWhat are the basic tax rates for an individual and a corporation?Solution:Individuals have basic tax rates of 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%

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Chapter 1: An Introduction to Taxation5that are applied to their ordinary income. A corporation’s basic tax rates rates are15%, 25%, 34%, and 35%, excluding surtaxes.25. [LO 1.4]FiduciariesWhat are two fiduciary entities and how are they created? Define grantor, trustee, andbeneficiary for a trust.Solution:Trusts and estates are two fiduciary entities;atrustisestablished by agrantor whoappoints a trustee tomanagethe assetsfor the benefitof the trust’s beneficiaries.An estate is an entity that is created on the death of a personthat providesmanagementfortheassets in the decedent’sestateuntil they can be distributed tothe beneficiaries. A grantor is the person who creates the trust when assets areplaced in the trust for the benefit of the beneficiaries. The trustee is the personselected by the grantor to oversee the assets and ensure the trust functions asspecified by the grantor. The beneficiary of the trust is the person for whom thetrust was established and who is to benefit from the income from the trust (anincome beneficiary) or receive the assets when the trust is closed (theremainderman).26. [LO 1.5]Sole ProprietorshipsWhat are threecharacteristics of a sole proprietorship? Are these characteristics the same asor different from those of a partnership? What are three characteristics of a limited liabilitycompany that differ from those of a partnership?Solution:Only onetaxable person, who must be an individual, can own a sole proprietorship.The sole proprietor is personally liable for all debts of the business. The soleproprietor cannot be an employee of the businessand must pay self-employmenttax. The results of operations of the sole proprietorship are reported on theSchedule C and these are then included in the owner’s personal tax return.A partnership must have more than one owner. A general partner is liable forpartnership debts but limited partners are only liable for their investment in thepartnership. Like sole proprietors, partners cannot be employees of the partnershipand general partners are required to pay self-employment tax. Althoughpartnerships do not pay taxes directly, they must file information tax returns. Theincome/loss from the partnership flows through to the partners and is reported ontheir own tax returns.Partnerspay any taxes owing on the income itemsbut loss isdeductible only if a partner has sufficient basis. A partner’s basis begins with his orher investment in the partnership and is increased for the partner’s share ofpartnership liabilities.Partnerships and limited liability companies differ in a number of ways. Owners ofpartnerships are partners while owners of limited liability companies are calledmembers. There are no legal requirements to set up a partnership but a limitedliability company must be established according to the laws of the state ofdomicile. Limited liability companies can elect to be taxed as corporations whilepartnerships do not have that option. In some states, a limited liability companymay have only one owner but a partnership must have two or more owners.Onlythe managing membersof a limited liability company may be subject to self-

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6Solutions Manual for Taxation for Decision Makersemployment taxes.27. [LO 1.5]CorporationsCompare a C corporation to an S corporation.Solution:The principal difference between a C corporation and an S corporation is in themethod of taxation. A corporation pays a tax directly on its income. Any net after-tax income that is distributed to its shareholders as dividends is subject to a secondlevel of tax. Thus, these corporate earnings are said to be subject to double taxation.An S corporation’s income flows directly through to its shareholders (whether thereis an actual distribution of this income in cash or not) undiminished by taxes at thecorporate level. The income is then taxed once only at the shareholder level. Thecorporation can then make actual distributions of this previously-taxed income tothe S corporation shareholders without any additional taxes due. There are anumber of other differences in that the number and type of S corporationshareholders is limited; it can only have one class of stock outstanding, and itschoice of tax year is restricted. None of these restrictions apply to a C corporation.Other items of comparison could be drawn from the table in the text comparingbusiness entity attributes.Crunch the Numbers28. [LO 1.1]Property TaxesDaneCity'stotalassessedvaluationforallofthepropertyinitsjurisdictionis$4,000,000,000. It needs $20,000,000 in revenue for the services it provides its citizens. Joeowns property that is assessed at $150,000. How much will he pay in property taxes?Solution:Hewill pay $750. $20,000,000 / $4,000,000,000 = .005 or 5 mills per $1 ofvaluation.$150,000 x .005 = $750 in tax29. [LO 1.1]FICA TaxIf a taxpayer has $40,000 of employee salary in 2016, how much will be withheld for theSocial Security andMedicare taxes?Solution:$40,000 x 7.65% = $3,06030. [LO 1.1]FICA TaxesIf a taxpayer has $140,000 of employee salary, how much will be withheld for the SocialSecurity and Medicare taxes in 2016?Solution:9,377is withheld for FICA taxes in 2016.$118,500 x 6.2% =$7,347$140,000 x 1.45% =2,030Total$9,37731. [LO 1.4]Taxable IncomeDetermine Amy's taxable income for 2016 if she has $40,000 of salary income, is single, andhas $10,350 in total allowable deductions.

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Chapter 1: An Introduction to Taxation7Solution:Taxableincome = $29,650$40,000Salaryminus10,350Deductionsequals$29,650Taxable income32. [LO 1.4]Taxable IncomeMarlee is a single parent with $25,450 in total allowable deductions and qualifies as head ofhousehold for 2016. Determine hertaxable income if she has a salary of $71,000 and interestincome of $1,500.Solution:Taxable income = $47,050$71,000Salaryplus1,500Interest incomeminus25,450Deductionsequals$47,050Taxable income33. [LO 1.4]Taxable IncomeDetermine a corporation's taxable income if it has $450,000 of gross receipts, $145,000 costof goods sold, $276,000 of deductible business expenses, $20,000 of gain on the sale ofmachinery, and $500 of interest income from State of New York bonds.Solution:Taxable income = $49,000$450,000Gross receiptsminus145,000Cost of goods soldequals$305,000Gross incomeplus20,000Gain on saleminus276,000Expensesequals$49,000Taxable incomeThe $500 interest on State of New Yorkbonds is tax-exempt.34. [LO 1.4]Taxable IncomeThe Warner Corporation has gross income of $560,000. It has business expenses of $325,000,a capital loss of $20,000, and $2,500 of interest income on temporary investments. What isthecorporation's taxable income?Solution:Taxable income = $237,500$560,000Gross incomeplus2,500Interest incomeminus325,000Expensesequals$237,500Taxable incomeThe $20,000 capital loss is not deductible currently.35.[LO 1.4]Taxable IncomeDetermine George and Mary's taxable income and tax liability for 2016 if George has $65,000and Mary has $45,000 of salary income, they have $36,200 of total allowable deductions, andthey file a joint tax return.

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8Solutions Manual for Taxation for Decision MakersSolution:Taxable income = $73,800George's salary$65,000plusMary's salary45,000equalsGross income$110,000minusDeductions36,200equalsTaxable income$73,80036. [LO 1.4]Determining Tax LiabilityRefer to the information in problem 31. Determine Amy's income taxliability for 2016.Solution:Taxable income = $29,650; income tax = $4,023.75.Income Tax: ($9,275 x 10%) + ($20,375 x 15%) = $3,983.75.37. [LO 1.4]Determining Tax LiabilityRefer to the information in problem 32. Determine Marlee's income taxliability for 2016.Solution:Taxable income = $47,050; income tax = 6,395.Income Tax:[($47,050-$13,250)x 15%]+ $1,325= $6,39538. [LO 1.4]Determining Tax LiabilityRefer to the information in problem 33. Determine the corporation's income tax liability.Solution:Taxable income = $49,000;income tax = $7,350.Income Tax:$49,000 x 15% = $7,350.39. [LO 1.4]Determining Tax LiabilityRefer to the information in problem 34. Determine Warner Corporation's income tax liability.Solution:Taxable income =$237,500; Income tax = $75,875[($237,500-$100,000) x 39%] + $22,250 = $75,875(The $20,000 capital loss is not deductible currently.)40. [LO 1.4]Marriage PenaltySally and Jim are married and have taxable income in2016 of $160,000. If they could filetheir income tax as single individuals, each of them would have taxable income of $80,000.Do they have a marriage penalty when they file their joint return? If so, what is the amount ofthe penalty?Solution:They have a marriage penalty of $243($31,785.50-$31,542.50).MFJ:[($160,000-$151,900) x 28%] + $29,517.50 = $31,785.50Single: [($80,000-$37,650) x 25%] + $5,183.75 = $15,771.25 x 2 = $31,542.5041. [LO 1.4]Joint vs. Single FilingConrad and Anita (acollege student with no income) plan to marry on December 21, 2016.Filing jointly, they expect to have $180,000 of taxable income for the year. If they wait untilJanuary of 2017to marry, Conrad will file as a single person and report the $180,000 oftaxable income on his separate return.

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Chapter 1: An Introduction to Taxation9a. Will it be to their advantage to marry before the end of 2016or should they wait until2017?b. How much in tax will they save or have to pay extra if they marry in 2016?c. How would your answers change ifConrad and Anita each expect $90,000 of taxableincome in 2016?Solution:a.It will be to their advantage to marry in 2016.b.By marrying before the end of 2016and filing jointly, they save$6,051.25($43,436.75-$37,385.50)in taxes.MFJ:[($180,000-$151,900) x 28%] + $29,517.50 = $37,385.50Single: [($180,000-$91,150) x 28%] + $18,558.75 = $43,436.75c. If they each have $90,000 of income, they would each pay $18,271.25 in taxes andthey would then have a marriage penalty of$842.50 ($37,385-$36,542.50). In thiscase, they would be slightly better off by postponing their wedding until 2016.Tax on $90,000 (Single):[($90,000-$37,650) x 25%] + $5,183.75 = $18,271.25$18,271.25 x 2 = $36,542.5042. [LO 1.4]Income Tax LiabilityCarrie and Stephen have gross salary and wages of $76,000 in 2016 and file a joint return.They have $27,150 of total allowable deductions and a $240 child care credit. Determinetheir taxable income and their tax liability.Solution:Taxable income = $48,850 and the net tax liability = $6,160.$76,000 salary and wages-$27,150 allowabledeductions= $48,850 taxable income.Income tax liability is: $1,855 + .15 x [$48,850-$18,550] = $6,400$6,400-$240 credit = $6,16043. [LO 1.4]Tax LiabilityAn estate has $20,000 of taxable income in 2016. What amount of tax will the estate pay if itfails to distribute the income to the beneficiaries?Solution:The estate will pay $6,215.60.$2,550 x 15% =$382.50$3,400 x 25% =850.00$3,100 x 28% =868.00$3,350 x 33% =1,105.50$7,600 x 39.6 =3,009.60Total tax$6,215.6044. [LO 1.4]TaxRatesPerform the calculations to prove that the 5 percent surtax on corporate income between$100,000 and$335,000 equals the benefit that the corporation enjoys on income of no morethan $100,000.Solution: .05 x ($335,000-$100,000) = $11,750$50,000 (.34-.15) = $9,500($75,000-$50,000)(.34-.25) = $2,250.

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10Solutions Manual for Taxation for Decision Makers$9,500 + $2,250 = $11,75045. [LO 1.4]TaxRatesPerform the calculation to prove that the 3 percent surtax on corporate income between$15,000,000 and $18,333,333 equals the benefit of the 34 percent tax rate on income of nomore than $10,000,000.Solution:.03x($18,333,333-$15,000,000) = $100,000(.35-.34)($10,000,000) = $100,00046. [LO 1.5]TaxLiabilityJohn has taxable income of $30,000. William has taxable income of $60,000. Determine their2016 income taxes if they are both single individuals. Compare their incomes andtheirincome taxes. What does this illustrate?Solution:William’s income is twice John’s, but his taxes are 2.67 ($10,771.25/$4,036.25)times John’s. This illustrates the progressive nature of the tax system as well asvertical equity.[($30,000-$9,275) x 15%] + $927.50 = $4,036.25[($60,000-$37,650) x 25%] + $5,183.75 = $10,771.2547. [LO 1.5]Net Operating LossLilikoi Corporation began business in 2014. Lilikoi earned taxable income of $40,000 in2014 and $120,000 in 2015. For 2016,Lilikoi Corporation has a net operating loss of$50,000 and decides to carry the loss back, filing a refund claim. Compute the amount ofcorporate income tax that Lilikoi paid for 2014 and 2015 and then determine the amount oftax that will be refunded from carrying back the 2016 NOL.Solution:Lilikoi paid $6,000 tax for 2014 and $30,050 tax for 2015. Lilikoi will have arefund of $9,900 from carrying back $40,000 of the 2016 loss to 2014 and $10,000of the loss to 2015. (Note that Lilikoi cannot carry the loss back to only 2015without first carrying it back to 2014.)Tax paid for 2014 on $40,000 was $40,000 x 15% = $6,000Tax paid for 2015 on $120,000 was[($20,000 x 39%)+ $22,250]= $30,050.The $10,000 loss that is carried back to 2015reduces the taxable income for thatyear from $120,000 to $110,000 saving tax at the 39% rate that applies to incomebetween $110,000 and $120,000.Tax refund from 2016 loss is ($40,000 x 15%) + ($10,000 x 39%) = $9,90048. [LO 1.5]DeterminingTax LiabilityHunter Corporation has $250,000 ingrossincome, $125,000 in deductible business expenses,and a $12,000 business tax credit. Determine the corporation's net tax liability.Solution:The net tax liability is $20,000.$250,000 gross income-$125,000 expenses = $125,000 taxable income.

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Chapter 1: An Introduction to Taxation11The income tax liability is:[($25,000 x 39%)+ $22,250]= $32,000gross tax$32,000-$12,000 tax credit = $20,000 net tax49. [LO 1.5]DeterminingTax LiabilityCarolyn has a 50 percent interest in ageneralpartnership that has a $14,000 loss for the year.She materially participates in the partnership.Her basisin the partnershipis $10,000.Shealso has salary from other employment of $46,000. If she is single with $10,350 in allowabledeductions, what is her taxable income and her tax liability in 2016?Solution:Taxable income = $28,650 and the tax liability is $3,833.75$46,000Salaryminus7,000Partnership loss (50% x $14,000)equals$39,000Grossincomeminus10,350Deductionequals$28,650Taxable incomeTax: [($28,650-$9,275) x 15%] + $927.50 = $3,833.7550. [LO1.4 &1.5]Tax Liability ComparisonsJune and John decide to form a business. They each plan to contribute $20,000 inexchangefor a 50 percent interest in the business. They will then take out a bank loan for $30,000 tocover the balance of their working capital needs. They expect that the business will make aprofit of $64,000 in the first year and that it will not make any cash distributions that year.Excluding the business income, June, who files as head of household, has $475,000 of otherordinary taxable income. John is married and files a joint return; he and his wife have$130,000 of other ordinary taxable income. They want to know how much tax the businesswill pay and how much additional tax they will personally pay in 2016 if they form thebusiness as a partnership, S corporation, or C corporation. Consider only income taxes.Solution:Partnership: Pays notax. June and John are each taxed on the $32,000 passedthrough to them at their marginal tax rates.To determine their marginal tax rates, find the tax bracket in which their othertaxable income falls. (Note that the “other ordinary taxable income” is provided;either the standard or their itemized deductions and the personal exemptions havealready been subtracted.) June’s $475,000 of other ordinary taxable income putsher in the 39.6% marginal tax bracket because she is a head of household withtaxable income over $441,000. John’s $32,000 straddles the 25% and 28%marginal tax brackets because his $130,000 of taxable income plus the additional$32,000 exceeds $151,900–the 25% tax bracket. Thus, $21,900 is taxed at 25%and $10,100 ($162,000-$151,900) is taxed at 28% for a married taxpayer filing ajoint return.June’s tax = $32,000 x 39.6% = $12,672.John’s tax = [$21,900 x 25% = $5,475] + [10,100 x 28%= $2,828] = $8,303.Together they pay a total of $20,975 in taxes.S Corporation: Pays no tax. June and John are each taxed on the $32,000 passedthrough to them at their marginal tax rates as shown above for the partnership andtogether they pay $20,975 in taxes.

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12Solutions Manual for Taxation for Decision MakersC Corporation: The corporation pays a tax of $11,000[$7,500+ ($64,000-$50,000)x 25%]= $11,000Neither June nor John pay any taxes as they received no distributions from thecorporation.Note the problem specified only income taxes; employment taxes are not includedin the solution to this problem.51. [LO1.4 &1.5]Tax Liability ComparisonsAssume the same facts as problem 50, except that the business expects to make a cashdistribution of $28,000 each to June and John the first year. Determine how much tax thebusiness will pay and how much additional tax they will personally pay if they form thebusiness as a partnership, S corporation, or C corporation. Consider only income taxes.Solution:Partnership: The answer does not change because June and John are taxed fully ontheir shares of income whether they are distributed or not and the partnership paysno tax. Thus, June’s tax is still $12,672 and John’s tax is $8,303for a total of$20,975in taxes. They pay no additional tax on the $28,000 distribution.S Corporation: The answer does not change because June and John are taxed fullyon their shares of income whether they are distributed or not and the S corporationpays no tax. Thus, June’s tax is still $12,672 and John’s tax is $8,303for a total of$20,975in taxes. They pay no additional tax on the $28,000 distribution.C Corporation: The corporation pays the same tax of $11,000 [($50,000 x 15%) +($14,000 x 25%)]. June and John, however, will now have to recognize $28,000 ofdividend income; John will be taxed at the 15% dividend rate but June will be taxedat 20% (the dividend rate for taxpayers in the 39.6% marginal tax bracket).June’s tax = $28,000 x 20% = $5,600.John’s tax = $28,000 x 15% = $4,200.The total tax for the corporation, June, and John is $20,800 ($11,000 + $5,600 +$4,200).Note the problem specified only income taxes; Medicare surtaxes and employmenttaxes are not included in the solution to this problem.52.[LO1.4 &1.5]Tax Liability ComparisonsAssume the same facts as problem 50, except that John and Juneexpect the business willhave a $44,000 loss in the first year (instead of a $64,000 profit) and will not make any cashdistributions. Determine the income tax savings in the current year for the business and forthem personally if they form the business as a partnership, S corporation, or C corporation.(They both materially participate in the business and their marginal tax bracket will notchange because of the business loss.)Solution:Partnership: The partnership does not benefit from the loss. June and John are eachallocated $22,000 of loss and can deduct the loss against their other incomebecause they have sufficient basis in the partnership [$15,000 invested + ($30,000bank loan x 50%) = $30,000 basis before loss-$22,000 loss = $8,000 ending

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Chapter 1: An Introduction to Taxation13basis]. June’s and John’s incomes are high enough for them to remain fully in theirrespective marginal tax rates of 39.6% and 25%. June benefits from a reduction intaxes of $8,712 ($22,000 x 39.6%) and John saves $5,500 ($22,000 x 25%) in taxesat his marginal tax rate. The total tax savings for both are $14,212 ($8,712 +$5,500).S Corporation: The S corporation does not benefit from the loss. June and John areeach allocated $22,000 of the loss but they can only deduct $15,000 of this lossagainst their other income because their deduction is limited to their basis in their Scorporation stock (which does not include any of the corporation’s liabilities).Thus, June benefits from a reduction in taxes of $5,940 ($15,000 x 39.6%) at hermarginal tax rate. John reduces his taxes by $3,750 ($15,000 x 25%) at hismarginal tax rate. They will each carry their excess $7,000 loss forward; theselosses can be deducted in a future year when they have sufficient basis. The totaltax savings for the current year is $9,690 ($5,940 + $3,750).C Corporation: Neither June nor John have any current tax savings from the $44,000loss. As a new corporation, it can only carry its loss forward to offset income (andrealize tax savings) in a future year. Losses of a C corporation do not pass throughto shareholders.Note the problem specified only income taxes; Medicare surtaxes and employmenttaxes were not included in the solution.53. [LO 1.4 & 1.5Choice of Business Entity]Clara and Charles decide to form a business. They each plan to contribute $15,000 inexchange for a 50 percent interest. The business will borrow $20,000 to cover the balance ofits working capital needs. In their business plan, Clara and Charles show that the businesswill have a loss of $54,000 in its first year. In the second year, however, the business willhave a profit of $60,000 and they will each be able to withdraw $5,000 from the business.Clara is in the 28 percent marginal tax bracket and Charles is in the 25 percent marginal taxbracket.a.Determine the taxes paid by the business (if any) in the first and second year if theyorganize the business as (1) a partnership, (2) an S corporation and (3) a C corporation.b.Determine Clara's and Charles's income tax savings in the first year and their bases in thebusiness at year-end if they organize the business as (1) a partnership, (2) an Scorporation, and (3) a C corporation.c.Determine the income tax Clara and Charles will pay in the second year from businessoperations and their bases in the business at year-end if they organize the business as (1)a partnership, (2) an S corporation, and (3) a C corporation.Solution:a. (1) The partnership does not pay any tax in years 1 or 2.(2)The S corporation does not pay any tax in years 1 or 2.(3) The C corporation pays no tax in year 1 but its year-1 loss can be carried forward toyear 2 to offset $54,000 of its year-2 $60,000 income; it will pay a tax of $900 ($6,000 x15%) on this remaining $6,000 income in year 2.

Taxation For Decision Makers, 2017th Edition Solution Manual - Page 15 preview image

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14Solutions Manual for Taxation for Decision Makersb.(1) Tax savings for first year of partnership: Clara and Charles are each allocated$27,000 of loss and each can deduct $25,000 of the loss (the extent of basis [$15,000investment + (50% x $20,000 loan)]. Clara’s tax savings will be $7,000 ($25,000deductible loss x 28%) and Charles’s tax savings will be $6,250 ($25,000 deductible lossx 25%). The excess loss is carried forward to the next year.Partner’s basis computations:$15,000Partner’s original investment+10,000Partner’s share of liabilities ($20,000 loan x 50%)$25,000Basis before deducting loss-25,000Deductible loss ($54,000 loss x 50% = $27,000 but limited to basisand $2,000 excess loss carried forward)0Basis at end of first year(2) Taxsavings for first year of S corporation: Clara and Charles are each allocated$27,000 of loss and can deduct loss to the extent of the basis in the S corporation stock.Clara’s tax savings will be $4,200 ($15,000 deductible loss x 28%) and Charles’s savingswill be $3,750 ($15,000 deductible loss x 25%).S corporation shareholder’s stock basis computations:$15,000Shareholder’s original investment-15,000Deductible loss ($54,000 loss x 50% = $27,000 but limited to basisand $12,000 excess losscarried forward)0Basis at end of first yearNote that an S corporation shareholder does not increase stock basis for any corporateliabilities.(3) First year of C corporation: No effect on Clara or Charles. Their basis in stockremains $15,000 each.c. (1) Income tax for second year of partnership: Clara pays $7,840 income tax [($30,000profit-$2,000 loss carried forward) x 28%] and Charles pays $7,000 income tax[($30,000 profit-$2,000 loss carried forward) x 25%]. The cash distribution is not taxedbut is a reduction of basis.Partner’s basis computations:0Basis at end of first year$30,000Year 2 profit ($60,000 x 50%)-5,000Cash distribution$25,000Subtotal-2,000Deduct loss carried forward from previous year$23,000Basis at endof second year(2) Income tax for second year of S corporation: Clara pays $5,040 in tax [($30,000 profit-$12,000 loss carried forward) x 28%] and Charles pays $4,500 tax [($30,000 profit-$12,000 loss carried forward) x 25%]. The cashdistribution is not taxed but is a reductionof basis.

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Chapter 1: An Introduction to Taxation15S corporation shareholder’s stock basis computations:0Basis at end of first year$30,000Year 2 profit ($60,000 x 50%)-5,000Cash distribution$25,000Subtotal-12,000Deduct loss carried forward from previous year$13,000Basis at end of second year(3) Income tax for second year of C corporation: Clara and Charles each pay $750 tax ontheir dividend income ($5,000 dividend income x 15% dividend rate = $750 tax). Theirbasis in thecorporate stock remains $15,000.54. [LO 1.5]Partnership BasisCarl is a 30 percent partner in the CCF Partnership. At the beginning of the year, his basis inthe partnership is $4,000. The partnership reports $7,000 of ordinary income anddistributes$3,000 to the partners. What is Carl's basis at the end of the year?Solution:His basis is $5,200.$4,000 beginning basis + (30% x $7,000 partnership income)–(30% x $3,000distribution) = $4,000 + $2,100-$900 = $5,200DevelopPlanning Skills55. [LO 1.4]Single vs. Married Filing StatusJohn and Martha are planning to be married. Both are professionals each with taxableincomes of $89,700 annually. They are deciding on a wedding date. They have two dates tochoose from: December 14, 2016, or January 11, 2017. If they marry on December 14, 2016,they will have to choose between married filing separately and married filing jointly. Is therean advantage to either method of filing? If they postpone their wedding until the January dateand file as single persons, will they reduce their tax bill for 2016?Solution:Married Filing Separately: [($89,700-$75,950) x 28%] + $14,758.75 = $18,608.75$18,608.75 x 2 = $37,217.50Married Filing Jointly: [($179,400-$151,900) x 28%] + $29,517.50= $37,217.50Single: [($89,700-$37,650) x 25%] + $5,183.75 = $18,196.25x 2 = $36,392.50It makes no difference if they marry this year and file either as married filing jointly orseparately. If they postpone the wedding until next year,they will save $825($37,217.50-$36,392.50) in taxes filing as single individuals this year.56. [LO1.4 &1.5]Total Tax ComparisonJeremy is setting up a service business. He can either operate the business as a soleproprietorship or he can incorporate as a regular C corporation. He expects that the businesswill have gross income of $80,000 in the first year with expenses of $12,000 excluding the

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